Piling On: Goldman Downgrade Hammers Retailers

Pssst! Here's an investing tip: Higher interest rates are bad news for retail stocks.

Goldman Sachs let everyone in on the secret late Tuesday (if you're a client) and Wednesday (if you're the rest of us), downgrading retail stocks in anticipation of slower consumer spending. Predictably, retail stocks declined, led by a 13% haircut for Kohl's (KSS Quote) and a 7% pullback in Wal-Mart (WMT Quote), further dimming the outlook for a sector that looks to be hit hard in coming months.

Going Macro

Citing the macroeconomic outlook, not individual companies' fundamentals, Goldman's retail team lowered its ratings on Wal-Mart, Target (TGT Quote), Costco (COST Quote) and Kohl's to market outperformer from recommended for purchase.

Red Ink Goldman call batters retail stocks
Company	Stock movement Wednesday
Kohl's (KSS Quote)	-9.5%
Target (TGT Quote)	-7.3%
Wal-Mart (WMT Quote)	-7.2%
Tuesday Morning (TUES Quote)	-7.2%
Lowe's (LOW Quote)	-6.2%
Costco (COST Quote)	-6.1%
Tiffany (TIF Quote)	-6%
TJX (TJX Quote)	-5.9%

Goldman also reduced ratings on department store chains Federated (FD Quote), May Stores (MAY Quote) and Neiman Marcus (NMG.A Quote) to market performer from market outperformer. And among specialty retailers, it cut ratings on Tiffany (TIF Quote), Tuesday Morning (TUES Quote) and Polo Ralph Lauren (RL Quote) to market outperformer from recommended for purchase, while downgrading Abercrombie & Fitch (ANF Quote) to market performer from recommended for purchase. TJX (TJX Quote) and Ross Stores (ROST Quote) moved to market performer from market outperformer.

But then again, most retailers have been lagging for a while on these same concerns about higher interest rates and slowing sales growth. Just three of the stocks on Goldman's downgrade list -- Kohl's, up 44% on the year; Ross, up 17%; and Costco, up 20% -- have risen since the end of 1999. In fact, before the downgrade, the stocks mentioned by Goldman today had fallen 9% since the end of 1999, and had slipped 6% over the last 52 weeks, albeit from pretty rich valuations.

Sentimental Fools

The Goldman analysts don't see any near-term catalysts sparking any life in retail shares. Spending will likely slow. Earnings aren't likely to beat expectations, as they have in the last few years, and costs of doing business -- like labor and raw materials -- are rising. That adds up to not much fun for the sector.

"Sentiment has changed, and the consumer has changed," says one hedge fund manager who didn't want to be named and has been increasing short positions for the last few months. The last time there were worries about the economy, during the fall of 1998, the Fed responded with three interest rate cuts. That ain't going to happen this time. "The Fed is absolutely not easing, and is absolutely raising rates," the hedge fund manager says. Possibly spelling even shorter-term woe for the sector, retailers are expected to report below-plan April same-store sales tonight and tomorrow, in part due to bad weather.

That doesn't mean that all retailers are going to be hit equally. The rich will likely keep buying Prada pumps. But midmarket retailers, like Talbots (TLB Quote), may get squashed if consumers start cutting back, the hedgie says. Supermarkets, drug stores and discounters aren't as susceptible to slowdowns as are specialty retailers and department stores.

The End of the Tunnel

And some optimists still see light in yonder retail. Donaldson Lufkin & Jenrette's retail team professed its disdain for macroeconomic calls like the one Goldman made. Retail is a stock picker's market, they say. While they acknowledge that higher rates will likely slow spending, DLJ reiterated its own strategy: Buy companies showing accelerating earnings, like Circuit City (CC Quote) and Best Buy (BBY Quote), and buy the big premium names -- Home Depot (HD Quote), Target, Lowe's (LOW Quote), Costco and Wal-Mart -- on the dips. (DLJ has done banking for Costco.)

DLJ says it was just reiterating the strategy it's had since January. Same with other brokerage houses in their responses to Goldman. Hedge fund managers have been shorting retailers for a while now. And indeed, the investing climate for retail stocks looks pretty much the same today as it did yesterday -- or last week.

Except that Goldman is Goldman. And because of that, its call may grab the attention of a whole new group of investors, ones who -- until today -- hadn't realized how bad higher interest rates could be for retail stocks.